Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 20 Step 2: Exposure Mapping (or Financial Mapping) In this step, the user identifies the various components of an earnings stream whose value can change with market fluctuations and puts them in the form of an equation. The user must recognize the market risk factors the corporation faces and define how the value of the exposure is affected by these factors. Examples of these factors are price, volume, basis, interest rate, foreign exchange, correlations, and seasonality. Typically, the factors differ for each company, and there is no standard set. Varying levels of complexity can be used to model the exposure, and there are tradeoffs between the cost and time to model versus the speed of obtaining an answer. One such level of complexity is to determine how business volume is treated. It can be treated as a function of the market factor, as a separate random variable, or held fixed as a constant. Step 3: Scenario Generation The scenario generation step has two tasks. The first is to select a forecasting technique for the market factors in the earnings exposure that the user mapped in Step 2. Many types of forecasting exist, and they can be grouped into the three main categories listed below. No one approach is best for all needs. Current market information: This forecasting technique is based on the efficient market hypothesis that everything currently known about an asset is already reflected in its price. It also assumes that the market reacts instantly to new information on the asset so that it is possible to study what the market thinks by studying the current spot, futures, forwards, and options prices. The limitation of this technique is that it is difficult to use in illiquid markets with little data. Econometric models: This approach calls for the use of econometric techniques and time-series analysis that incorporate macroeconomic variables. Two types of data are needed: financial time-series data and economic time-series data. Probabilistic models: These models are unique company-based models in which the probability of each scenario is assessed. The second task of Step 3 is to generate the scenarios using Monte Carlo simulation. Each scenario defines a unique path that the market factor can take over the specified time horizon. All the paths generated (price path, interest rate path, etc.) form a probability distribution. The number of scenarios or simulations needed must be enough to follow the basic principles of Monte Carlo simulation and convergence. Step 4: Valuation The valuation step substitutes each of the market factors’ simulated paths into the exposure mapping and generates a distribution of financial outcomes. See the Corporate Metrics publication by Risk Metrics Group for more detail. This is the probability distribution of future earnings results. If the exposure mapping was the revenue from the sale of Product A, then this